Amazon, Procter & Gamble, and the Underpants Gnomes

Co-locating is a gimmick. Co-packaging is Amazon's entire business, and it becomes a tall order when the supply chain is balkanized.

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It was 1998 when South Park introduced us to the underpants gnomes, a group of subterranean entrepreneurs trafficking in dirty laundry. They had a three-step business plan:

1. Collect Underpants
2. ???
3. Profit

In the 15 years since "Gnomes" first aired, these little guys have become a kind of grand metaphor, cited by the New York Times, Forbes, and the Wall Street Journal, and used to describe everything from dot-com startups to American presidents. They illustrate – rather colorfully – the idea that it's not enough to know where you're going. You also need a plan for getting there.

Amazon (NASDAQ:AMZN) sells underpants and does just fine with them, thank you very much, but toilet paper may be the online retailer's undoing. Amazon now shares warehouse space with Procter & Gamble (NYSE:PG), and is in talks to do the same with other vendors, including Seventh Generation Inc. and Kimberly-Clark Corp (NYSE:KMB). The intention is to ship personal care products straight from the assembly line to the customer, eliminating the need to warehouse them.

Sounds efficient, right? The Wall Street Journal thinks so, arguing that "co-location reduces the cost of storing bulky items like diapers and toilet paper and frees up space for the Web retailer to stock higher-margin goods in its own distribution centers." The Daily Ticker agrees. "[W]hy should P&G make the paper towels in one manufacturing facility, ship the product to a warehouse, which then ships to Amazon or to a store, when it could directly ship it to you right from the start?"

The move is just one part of a larger strategy to decentralize Amazon's supply chain. Over the last few years, the company has been opening fulfillment centers around major cities, trying to speed up delivery times and make possible new lines of business like grocery delivery. Where once Amazon shipped everything out of a handful of massive warehouses, it now relies on a system of smaller, more proximal depots. Again – seems efficient, doesn't it?

But remember the underpants gnomes. The retailer still has to get its products to customers, and in Amazon's case, the cost of shipping is the question mark. The company has almost no ability to pass these expenses on to customers. Prime Membership gets customers (and up to four family members) unlimited 2-day shipping for $79/year. Nonmembers can take advantage of free shipping on larger orders, and a ubiquitous $3.99 option for lesser hauls.

So long as Amazon can package everything in a single box, then all is well. If it needs to ship items separately, then costs quickly escalate. The model turns into something like a milk delivery service – not worth it.

Co-locating is a gimmick. Co-packaging is Amazon's entire business, and it becomes a tall order when the supply chain is balkanized.

Consider that last year Amazon introduced a new "add-on" category for small items. Now, they'll only ship with a minimum order of $25. It may be that too many Prime members were demanding rush delivery of toothpicks. In any event, Amazon is trying to get order sizes up. Of the three add-on items I've purchased in 2013, however, two came in separate boxes, from different fulfillment centers. Oops.

A second problem is the economics of paper towels. There's a reason that P&G doesn't have a subscription service, and won't ship a 3-pack of Bounty or a box of Tide to your front door – something it could do very well without Amazon, and in fact, something it could have done at any point in its 175-year history. The expense would be prohibitive. High-bulk, low-margin items are better suited to trains than to delivery trucks; they're more practical in an overloaded shopping cart than under the arms of a footsore mailman.

Contrary to what the Wall Street Journal article proposed, the lack of high-margin items is a liability. It ensures that, for every Amazon package leaving a P&G facility, there's little opportunity to make up the shipping costs. In fairness, toothpaste might raise the margins somewhat; but as Amazon enters the consumer care business, it's also moving down the food chain, and away from the delivery-friendly products like books and consumer electronics that used to account for most of its business. At the same time, the retailer appears to be finding fewer opportunities to ship all of these things together, in bulk. It is, in fact, losing the advantages of scale.

None of which changes the fact that brick-and-mortar stores like Wal-Mart (NYSE:WMT) are scared, or that they're following Amazon down the rabbit hole by offering increasingly inexpensive (read: subsidized) shipping options. Target (NYSE:TGT) has been aggressive in matching prices with its online counterpart, and last month it rolled out a diaper subscription plan to better compete with Amazon Mom. The question now is whether these big box stores can get away with the sort of prodigality – indeed, the flagrant gnomishness – that's now synonymous with Amazon.